Economic Update - July 3rd, 2017

Economic Update July 2017

Within this month’s update, we share with you a snapshot of economic occurrences both nationally and from around the globe.

Strong signs of continued world economic growth

– Europe has shaken off its recent rocky economic road to recovery

– Signs of life in Australian employment data

– Bank tax might limit growth in the ASX 200 during FY2018

We hope you find this month’s Economic Update as informative as always. If you have any feedback or would like to discuss any aspect of this report, please contact your Financial Adviser.

The Big Picture

At the start of a new financial year, it is natural to reflect on our performance over the last one.

In just one year, Europe has gone from being ‘the problem child’ of world economies to a shining light, growing at above trend with past political squabbles having largely subsided.

The US has moved from a grid-locked Obama government to an economy of great hope. True, Trump is struggling to make his mark on a number of fronts but much of the economic data have been solid. If Trump can get his tax cuts, infrastructure spend and healthcare reform through, the USA economy will also run at well above trend.

China has again shown the bear market proponents to have been premature in calling the end to its strong growth path. China has announced a truly massive multi-country infrastructure project, ‘One belt, one road’ that will link the eastern part of Asia with the rest of the continent, Europe and Africa. With the new government taking over later in 2017, there is a reasonable expectation that they will be even better able to continue strong growth.

Not all is well. The UK was doing quite well until May called an election – which backfired on her. She has a two-year deal with a conservative Northern Ireland party (DUP) to form government and see ‘Brexit’ through. How she goes in negotiating Brexit is the key to the success of the UK economy.

Australia too is not yet out of the woods. Recent employment data have shown strong signs of life but not yet for long enough to call it a strong recovery. With our latest economic growth at a low +1.7% over the year, the government needs to get some runs on the board in terms of policy and it would help if the Reserve Bank came to the party with a rate cut.

Some worry about house prices – particularly in Sydney. Students of the property market would know that it is entirely normal for average house prices to be stagnant for up to a decade and then go through a period of very rapid growth as we have just seen. We had similar price growth in Sydney up until 2003 only to be followed by a shallow but elongated dip into 2013. If we now start another ‘property price plateau’, it is just business as usual. That is our position.

So the next financial year is looking to be a source of more growth in stock market indexes around the world – but that gains in Australia may again be a bit more muted than others.

The ‘bank’ tax is likely to weigh on the share prices of the whole financials’ sector. As that sector is about 40% of the ASX 200, the other sectors will have to do most of the work over FY2018. Nevertheless, the ASX 200 should continue to pay solid dividends with franking credits.

The main economic events to monitor over the coming financial year are the Brexit negotiations in Europe and how the US Federal Reserve (“the Fed”) handles its so-called ‘budget repair’. From around September, the Fed plans to stop buying all of the new bonds necessary to completely offset those existing Treasuries that mature.

Given that they plan to reduce the 4.5 trillion dollars of debt to about 2.5 trillion over several years, skill will be needed but we think the Fed has learnt so much from its ‘tapering’ program of a few years ago.

Asset Classes

Australian Equities

The ASX 200 closed the financial year up +14.1%, including dividends, over 12 months. We are predicting a return to more average growth over FY18 with the ASX 200 finishing at about 6,150 next June. Of course, there will be bumps along the way especially round September-October as the Fed starts to move and Trump faces renewed uncertainty after the August recess for Congress ends.

Our market would have looked even stronger if the Telco sector hadn’t tanked -21.7% (including dividends) over the last 12 months. The Materials sector, including the likes of BHP and RIO, notched up a 12-month return of +25.8% including dividends.

Foreign Equities

The so-called ‘FANGs’, being Facebook, Amazon, Netflix, and Google (Alphabet), suffered some significant stock price volatility in the US in late June. Since these companies comprise 55% of the NASDAQ index and 37% of the S&P 500, their fortunes a have much wider impact on Wall Street – just as our big four banks do in the ASX 200.

While some question whether this could be the start of a market correction, others just point to the strong earnings growth. Of course, the massive fine the EU placed on Google for favouring its own advertising clients was a real negative but it only knocked its stock price down by about -2% on the day.

That the Fed gave a ‘pass’ to all of the banks in the second round of stress testing gave all markets a big kick up. These US banks can now start returning money to shareholders in dividends and share buy backs.

Capital gains were strong around a number of major markets during FY17: S&P 500 (+16.2%), London FTSE (+12.4%), German DAX (+31.5%) and the Japan Nikkei (+28.6%).

Bonds and Interest Rates

The RBA did not change rates in June and it has not signalled any inclination to do so – at least in the near future.

On the other hand, the US Fed hiked rates by 0.25% as was widely anticipated. The Fed further clarified its plan to ‘repair its balance sheet’ which markets took in their strides. It is expected that this program will be started in September but at such a gradual rate that markets should not be perturbed.

The Bank of England was also on hold and its governor stated that he did not expect to hike rates this year – but he would if business investment took off.

Other Assets

Both iron ore and oil prices continued their slides into June but, iron ore prices jumped by about +10% and finishing up +11.3% on the month.

Regional Analysis

Australia

There is now a reasonable prospect that the Australian labour market data may have started to recover without the need for extra policy changes. With now three successive months of good employment data, and a blip down in the unemployment rate, a new trend may have emerged.

The Governor of the RBA, Philip Lowe, has talked up the employment data by saying it is accommodating those people who prefer not to work full time. We believe that the almost non-existent wage inflation does not support this view.

To be on the safe side, we think a rate cut would help support the economy while the government tries to get its new budget through parliament. We see no risk to house-price inflation from a cut as we believe recent Sydney price behaviour has been following the usual pattern of house prices across all states for many decades.

June closed with Dr John Edwards, a former board member of the RBA, calling that there would be eight rate increases in the next two years. This is known in the trade as an attention seeking forecast. He can dine off it no matter what happens for six months. If he gets close he looks like a hero. If he is way off the market as we and seemingly everyone else thinks his forecast will be forgotten and so will he. Nothing to lose on John’s part!

China

China’s Industrial Profits jumped +15.7% (annualised) at the end of June to spark the reversal in the price of iron ore. Other data were also very strong such as the Purchasing Managers Index (PMI) for manufacturing up to 51.7 from 51.2 when 51.0 was expected. The services PMI was again stronger at 54.9 from 54.5.

We have no reason to expect China will miss its growth targets. Indeed, a former member of the People’s Bank of China was recently reported by CNBC as having said that he believes the new government – due to be appointed in October – is likely to be more aggressive in attaining economic growth targets. This reasoning is apparently based on the recent work having been done to stamp out corruption in some sections of government. The new government starts with a clean slate.

U.S.A. The US labour market lost some strength over the past few months – but not enough to worry. The last jobs number came in at +138,000 new jobs when +185,000 were expected – and the previous month’s data was revised down from +211,000 to +174,000.

There has been some noticeable price growth in the housing sector but not nearly enough to cause concern. The hike of 0.25% in the Fed Funds rate in June was the second for the year. Since this was widely anticipated and welcomed. It should not have any negative consequences for the economy. The big question is whether the budget repair program from September will effectively raise rates and hamper economic growth.

Given Trump’s problems with his second attempt at reformulating the healthcare policy, it does not look good for a swift move to infrastructure and tax cuts. However, we expressed such a view of a delay at the beginning of 2017. Perhaps the market just got a bit ahead of itself! But the Fed’s stress testing positive results for the banks have big implications for economic and market growth.

Europe

President Macron had a major victory in the wider French elections. This bodes well for economic stability in the region. The Purchasing Managers’ Index (PMI) for manufacturing hit a six-year high in June.

The President of the ECB, Mario Draghi, has announced no more rate cuts to follow. However, he is thought to have a gentle touch for when he eventually starts a tightening policy.

The UK is showing early signs of softening growth. There have been some differences of opinion from the Bank of England Governor, Mark Carney, and his Chief Economist. Carney was adamant that there will be no rate hikes this year. Then he said he would if business investment warranted it.

Rest of the World

North Korea continues to be a thorn in the side of the rest of the world with its missile testing program.

Qatar, too, has attracted negative attention. It is claimed that their actions have helped contribute to the strength of the terrorists in the Middle East. Sanctions are being discussed but Qatar happens to be the location of the largest US air base in the region!